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28.12.16

The long and winding path to reform

Source: PSE Dec/Jan 2017

Cllr Roger Phillips, chair of the Local Government Pension Scheme Advisory Board, analyses the opportunities and challenges facing the Local Government Pension Scheme (LGPS) in the short to medium term, and the plans to create eight multi-billion common investment vehicles.

The LGPS is unique in the public sector in that it is the only funded scheme of any size, and with that comes a more complicated structure, a more diverse set of risks and a wider range of stakeholders. Even though the 89 funds in England and Wales are under the same regulatory umbrella, the approach to operation and investment of scheme funds varies substantially across each individual administering authority.

Since Lord Hutton’s report in 2011, the LGPS has seen the establishment of the Scheme Advisory Board, the new LGPS Scheme in 2014, Local Pension Boards, and several consultations on the structure and investment of assets.

These consultations considered a spectrum of options, from complete merging of individual funds, to passive versus active investment and analysis of economies of scale in relation to both investment fees and performance.

While membership profiles and liabilities differ across funds, the overall investment strategy for maintaining performance over inflation has been achieved. Furthermore, the LGPS has a good track record of doing so at a competitive cost when compared with peers.

Nevertheless, following the consultations, a further challenge was set by the government. In his Summer Budget 2015, the then chancellor, George Osborne, announced that the government would work with the LGPS administering authorities to ensure that they pool investments to significantly reduce costs, while maintaining overall investment performance.

Later that year, a series of common criteria for delivering savings were issued, including size of pools and potential for infrastructure investment, inviting local authorities to come forward with their own proposals to meet them.

Asset pools

Currently, the majority of the LGPS is managed externally. For instance, the decisions on strategy are made at the administering authority, with investment managers implementing the strategy on a day-to-day basis and custodians holding the assets for the authorities. The individual LGPS funds range in size from the Isle of Wight at approximately £0.5bn to Greater Manchester at an estimated £17.1bn, London boroughs with one or two billion, with county and metropolitan funds in between.

The result of the pooling initiative will be the formation of eight pools, with individual administrating authorities investing assets via their pool.

The London boroughs had already set up a collective investment vehicle (CIV) and have already made good progress in adopting an Authorised Contractual Scheme (ACS) structure with most of the other pools appearing to be following a similar route.

The formidable task in the medium term for all funds will be navigating the regulatory framework through this period of change and remaining compliant. Particularly with MiFIDII (Markets in Financial Instruments Directive), ushering fundamental change in the status of local authorities in the investment market. The changes will take effect from January 2018, three months before it is expected that the new pools will be operational.

An uncertain world

In the long term, the pools should benefit from achieving savings in the form of economies of scale. However, any anticipated reductions in cost would need to be offset by the significant costs associated with setup. A realistic expectation is that the real value will take some time (i.e. more than one Parliament term) to be realised.

But even when these savings materialise they will not be in time or of the magnitude to address continued scheme deficits. Excellent investment performance will continue to be vital in order meet the requirements of deficit recovery plans and ensure the future sustainability of the scheme. However, in an uncertain world those investment strategies which have delivered in the past may not do so in the future.

With new challenges come new opportunities, and for the LGPS larger investment pools may mean direct access to markets that were previously out of reach. Over the years, the need to diversify away from the vanilla equity and bond portfolio has become more important as returns from traditional investment strategies have been left looking unremarkable.

A decade ago, the alternatives market for the LGPS was in its infancy and allocation to these asset classes (which would include private equity, infrastructure and hedge funds) was very low. Currently (2015 LA Universe) the allocation is around 7% to 8%. In the future, funds that may have seen these asset classes as too expensive will be able to benefit from the more diverse risk and return profiles these newer markets can offer.

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